In a recent call with a bond fund manager that we follow, he related that just five months ago, he was getting calls asking him “Why aren’t you short the Treasury? Everybody knows that interest rates are going to five percent.” As many of us know, not only did interest rates not rise, they have dropped sharply and had this manager based his decision making on what “everybody knows,” the investors in his strategy would have realized significant losses. Over the past two weeks, we too have heard a lot about what everybody knows. A big problem seems to be that when everybody knows something, it doesn’t actually happen at all or doesn’t happen in the way that the consensus thought it would happen. It is usually quite difficult making profitable investment decisions following the consensus.
The purpose of this article is not to agree or disagree with what “everybody knows will happen,” but to urge caution whenever you hear that phrase. The latest iteration of “everybody knows” is that a recession is coming. We have heard it in the media, from friends, and clients.
With respect to a recession, just about everyone can agree that the economy will eventually slide into a recession. First, though, we must agree on an acceptable definition of what a recession is. As you will see from the following paragraph, agreeing on when we are in a recession is as almost as difficult as making the prediction.
The National Bureau of Economic Research (NBER) does not define a recession by the popular “two consecutive quarters of decline in real GDP” methodology. Instead, the NBER defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
We like this definition because it includes a range of indicators as opposed to one narrowly defined statistic. In terms of determining when a recession begins or ends, the NBER has taken anywhere between 6-21 months to make a conclusive determination. As the NBER says on its website, “there is no fixed timing rule. The committee waits long enough so that the existence of a peak or trough is not in doubt, and until it can assign an accurate peak or trough date.” As can be seen from the above statement, defining recessions and knowing when we are in a recession, or back in an expansion, is not an agreed-upon science.
To further elaborate on the timing part of a recession, we can only rationally act on that information if we also know when the recession will occur. Concerning yield curve inversions, there have been five since 1978. The average time from the inversion to the S&P 500 peak is 13 months, and the median is 19 months. In two of the inversions, the S&P peaked within three months of the inversion and had risen 2.2% and 11.9% respectively to that point from the inversion. In the other three inversions, the S&P 500 peaked between 19 and 22 months after the inversion with the index rising 33%, 39%, and 22% after the inversion to the peak. Without knowing when the recession will occur, it is risky to make big changes to one’s investment strategy, and we (and many others) maintain that it is nearly impossible to predict when recessions will occur.
Another concern with “everybody knows” is defining who is “everybody.” From our experience, “everybody” tends to be the media as well as friends and colleagues. It is important to remember that the goal of the media is to attract viewers or readers not to help you to personally increase your wealth. In most cases, the experts making the statements lack specificity or don’t incur any consequence if they get it wrong. Therefore, we all need to have some level of skepticism regarding what we hear and read.
We often refer to our portfolios as “all-weather.” What we mean by this is that we create portfolio allocations in a way to avoid making significant adjustments based on judgments about near term events or our feelings as to what may occur. As noted above, we believe that making those types of judgments greatly increases the chance that one under performs by making an incorrect timing decision or an incorrect assumption.